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Interest rates play big role in farmland price boom and bust

The U.S. Department of Agriculture just announced that the price of farmland, averaged across the country, fell in 2015. That puts the official seal on what people involved with farming have felt for two years — the peak of the farmland boom has passed, and there is considerable potential to fall further.

This won’t affect the national economy, but it will be a big issue in farming areas. This drop also gives teachers like me examples to discuss economists.

Let’s start with 19th century British economist David Ricardo. He laid out how interest rates and the income derived from some asset combine to determine the market price of that asset. If the applicable interest rate rises, the price of the asset — whether it be a bond or an acre of farmland — falls. When rates fall, as they did in 2008-09, asset values rise.

Similarly, when the net income rises from an asset such as interest on bonds, rents on apartments or net profits from growing corn, the value of the asset itself rises. But when such annual income drops, the market value of the asset itself also drops.

For a perpetual asset like farmland that can produce income forever, the rational market value at any time is simply the annual income divided by the interest rate expressed. This assumes that both the interest rate and annual income will not vary in the future.

Note these qualifications. The calculated is what a rational person would pay. There is no buying in “irrational exuberance” or selling in a herd mentality. And the calculation depends on assumptions about the future that will not hold true.

That brings us to Nobel laureate Robert Shiller. As an expert on real estate, Shiller correctly identified the housing price bubble leading up to 2006 and predicted its collapse. He has been studying U.S. farmland prices for a decade and argues that they now are in an unsustainable bubble.

Shiller also is a leader among contemporary economists who question Ricardo’s “what would a rational person do” theorizing as inadequate. Instead of depending on “before-the-fact” assumptions of human nature, Shiller and other behavioral economists start from how human brains actually work as measured by modern psychologists.

There is great irony in Shiller’s 2013 Nobel. He shared it with two others, one of whom was Eugene Fama, a finance specialist who took Ricardo’s assumption of rationality to its ultimate ends. In Fama’s world of dominant rationality, bubbles cannot arise. He famously said, “The word ‘bubble’ drives me nuts,” in an interview for the Minneapolis Fed’s quarterly magazine.

This was weeks after first indications of the collapse of the largest bubble in the global economy in 80 years. Fama legitimately deserved the Nobel for his insightful scholarship over decades, but, on his key assumptions, history is proving him wrong and Shiller right.

The implications of the drop in farmland prices reach further, however, to macroeconomists like Federal Reserve Chairwoman Janet Yellen, former Minneapolis Fed chief Narayana Kocherlakota, and Paul Krugman, another Nobel economist. All have championed the ultra-low interest rate policy pursued by the Fed since 2008.

Krugman, and particularly Kocherlakota, have called for even greater monetary expansion. All three discount the effects of such low rates on asset prices. That is a serious error. Now the Yellen-led Fed is inching interest rates up, but the bubble in land prices has already happened.

As Ricardo explained 195 years ago, interest rates are one of the two factors that determine asset prices. Lower interest rates push up such prices. Farmland prices rose in part because ag commodity prices were high, part of a global commodities “supercycle” largely driven by the burgeoning Chinese economy. But they also rose because of unprecedentedly low interest rates.

Many macroeconomists argue that it is impossible to determine what a “correct” price is for an acre of land or a share of stock. If one cannot know that, how can one decide whether Fed policy is making farmland or bonds or apartment houses too expensive or too cheap? Better, they say, to look inflation of goods and services to guide monetary management.

This is disingenuous.

Yes, economists cannot objectively know some “correct” price for an asset. But when a central bank has kept rates below historic levels and some below the inflation rate for years in a row and prices of a wide range of assets have boomed in the while, the probability of cause and effect is high, to put it mildly.

And history shows that, unlike former Fed Chair Ben Bernanke’s sanguine views on the ease of mopping up busts after they occur, sharp rises followed by collapses of asset prices have real economic and social costs.

That brings us to farm country. Its Main Street and ag-related businesses are on a roller coaster. It won’t be the early 1980s all over, but we are getting into something big.

St. Paul economist and writer Edward Lotterman can be reached at boise@edlotterman.com.

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